WHAT IF ITALIAN COMPANIES DID LIKE THE AMERICANS? CAVALLINI AND GIETZMANN ANALYZE HOW AND UNDER WHAT CONDITIONS TO INTRODUCE CHAPTER 11 OF UNITED STATES BANKRUPTCY STATUTE INTO ITALIAN LAW
by Cesare Cavallini and Miles Gietzmann, Department of Legal Studies and Department of Accounting, Bocconi University
What would every Italian company like to see when they emerge from the long COVID lockdown? A fresh start for their balance sheets!
Obviously, the Italian legal system has well developed bankruptcy processes in place allowing debtors who can no longer pay their creditors to get a fresh start by liquidating assets to pay their debts or by creating a repayment plan. In a formal bankruptcy the debtor’s finances are reorganized. The debtors pay their creditors what they can afford. What they cannot afford is discharged. A debt discharged through bankruptcy is no longer enforceable against the debtor. However, these legal proceedings may take some time and the remaining company may be a shadow of its former self. This has motivated some commentators to pejoratively describe post-bankruptcy emerging firms as "zombies". While such a description is probably unfair it is interesting at this time to ask whether there are any other possibilities? One alternative approach is the fresh start accounting option under US Chapter 11 bankruptcy.
In its most stark form fresh start accounting allows a company to close business one night and, in the morning, open with a completely new balance sheet typically unencumbered with major debts. In some well-known cases the length of time between declaring bankruptcy and the fresh start company opening for business is minimal because on declaring bankruptcy the company simultaneously announces a prepack settlement outlining an agreed reorganization. So, the US approach can be rapid, and companies need not languish for weeks in administration. How though does the magic happen? The essential difference in the US is, creditors are incentivized to follow a loan to own strategy. Unfortunately, at the same time typically the shareholders of the original troubled company lose all interest in the company with the fulcrum debtors of the former company becoming the controlling shareholders of the new company. Clearly there is no magic for the former shareholders. If one’s policy objective was to promote speedy return of companies to the market place the US approach clearly has some merit. However, could such a system be implemented in Italy? We attempt to address this question in two ways. First, we will consider what it would mean for financial institutions and secondly what constructive reforms in part inspired by US practices were recently proposed by the European Commission.
In terms of institutions one sees immediately that if a company’s major creditor was a local bank, that bank may not find a loan to own opportunity an attractive option since managing and advising on day to day operations may not be a skill they specialize in. Yes, they can monitor daily cash flow but giving strategic advice in a specialized industry may not be within the bank’s core competencies. How does the US deal with this? The simple answer is that trading in the debt of distressed companies is made possible. Put simply a local bank can sell the distressed debt to a private equity reorganization specialist who then becomes the loan to own participant. In the US, the institutions that specialize in purchasing distressed debt are sometimes referred to unattractively as "vulture investors". The vulture investors make their money from taking control of the formally distressed company and getting it back on its feet as quickly as possible, so its equity value increases significantly. Aggressive reorganizations may involve systematic changes in the way the company is run which has implications for management and staff. Whether this could work in Italy would therefore depend upon whether sufficient "vultures" with their own finances and entrepreneurial spirit would be prepared to come forward and whether laws would allow them freedom to make sweeping organizational changes. Perhaps the fast-paced fresh start accounting methods of the US are a step too far?
Recognizing that some reform in bankruptcy procedures was necessary within the EU, the commission has come up with some new proposals. The EU Directive no. 1023/2019 follows selected features of US Chapter 11 bankruptcy. The Directive provides a model for preventive restructuring frameworks (PRFs) to avoid insolvency proceedings such as bankruptcy. In particular, these frameworks allow entrepreneurs to submit their creditors a restructuring plan aimed at restructuring their business through several measures such as changing the composition, conditions or structure of a debtor’s assets and liabilities or any other part of the debtor’s capital structure. The wide scope of these provisions, potentially including several kinds of financial measures, can probably allow a fresh start for the European companies' balance sheets. But there are still too many unknowns in this case. First, the Directive needs to be adopted within each national legal system. This fact can reasonably determine different adaptations of the EU law in accordance with the existing legal rules in each Member State. While some States could adopt a regulation for PRFs that authorizes companies to organize fresh start accounting, other States could forbid it by reducing the scope of PRFs. Second, the EU Directive requires that the PRF shall be not only be adopted by the parties who are affected by the plan such as creditors or equity holders but also confirmed by a judicial or administrative authority. These limitations will probably reduce the initial impact of PRFs involving fresh start accounting on national legal systems. However, it is reasonable to expect financial practices in individual states to exploit the potential of the Directive. National legal systems will have to ensure various ways of implementing the restructuring plan in accordance with the broad scope of the directive. This fits in well with the new structure of Italian insolvency legislation (Legislative Decree no 14/2019) which prioritizes the negotiated solutions for restructuring the companies’ financial crisis as opposed to liquidation solutions.
Thoughts of a quick fresh starts for some Italian businesses may be considered fanciful because we all know recovery will often be slow and difficult. However speedy attention by regulators on how to apply the new PRFs is essential. While US fresh start accounting has issues it does illustrate what is possible if regulators choose to focus upon innovative solutions in a post COVID environment.
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